Is Covid-19 response effective?
This is a supply shock to which the world has added a mandatory shutdown of the economy. As such, an effective response must be supply-side driven. Trying to stimulate aggregate demand with liquidity and public spending measures in a forced lockdown where any extra demand will not drive supply higher, may even drive it down.
A mandatory shutdown due to a supply shock cannot be solved alone with government spending or demand-side measures. Liquidity and lending facilities may support the already indebted and governments with already historic-low bond yields, as deficits are already going to soar due to automatic stabilizers. However, the economic sectors that are most at risk are the ones that find themselves with zero sales and no credit availability, predominantly small and medium enterprises in the service sector that have no assets to leverage and find rising working capital and no sales driving businesses to close.
The pandemic crisis can be addressed by providing safety protocols and sanitary equipment for businesses to continue to run and keep employment, as shutting down everything may create a larger social problem in the long term regardless of liquidity and fiscal policies. Demand-side policies rarely generate the desired effect in a forced shutdown of almost every sector. There is no demand to incentivize when the government orders the closing of all activities. And there is no supply to follow when the economic crisis creates a collapse in employment and consumption.
Shutting down the economy is an essential measure to gain time to control the virus, but we must understand the ripple effects and important ramifications of a complete shutdown. The global economy cannot go back to normal in one month. The impact may be severe, widespread, and exponential.
The decision to shut down the economy may cause long-lasting damages to job creation and businesses that cannot be unwound in a few months. It is essential to contain the virus spread and drastic measures are warranted, but each month means millions of unemployed and thousands of business closures.
Each month of lockdown means more than millions of unemployed. It means thousands of businesses that go bankrupt and must close forever.
The investment and financial implications are also severe.
The healthcare crisis must be tackled from three angles: prevention, testing and ensuring that treatment and vaccines will be widely available when ready. If governments fall prey to panic and damage the economic fabric of the country the economy may add a lasting recession to the fatalities of the epidemic, thus creating a larger, longer-lasting social and health challenge.
As Allen et al state, governments cannot freeze an economy, thaw it out a few months later and expect it to come back to life. Economies do not hibernate for the winter like a sleepy but otherwise unharmed and intact bear. Unless some specific steps are taken – steps we will outline in this book – the most likely outcome is that the economy thaws into a pile of mush.
Implications of freezing the economy are wide and varied.
Capital expenditure and research and development investment decisions are cut as companies focus on restoring balance sheet as well as reducing indebtedness that may soar due to the collapse in sales.
Citizens’ consumption and investment decisions must be postponed due to loss of jobs, reduction of salary or reduction of disposable income and savings due to loss of asset values. Furthermore, those consumption decisions may be changed dramatically due to fear of new waves of virus or simply concerns about new lockdowns.
The main issue here is the capacity of the monetary institution to support the economy in this crisis, given that interest remained below the zero-bound in many countries during the expansion years, and balance sheet expansion and asset purchases were in place before the Covid-19 outbreak in the eurozone, United States, Japan, United Kingdom and China.
Additionally, Latin America may be one of the most impacted regions, and one with few fiscal and monetary tools to address the crisis. A combination of loss of tourism, weaker trade, lower commodity prices and loss of foreign exchange reserves may lead to an economic recession and solvency problems in some of the most important economies.
We are already seeing sharp currency declines that are amplifying some dynamics we already saw in the past in the financial system regarding both record outflows in bonds and local currency bond spreads over international benchmarks (Hofmann, B. et al, April 2020).
Countries like Mexico or Brazil, that are important for the stability of the region and global growth, are not capable to solve their structural problems alone. Both fiscal and commercial deficit, jointly with a downturn of their main trading partners, can lead to solvency problems.
In this context, we should keep in mind the high U.S. dollar-denominated indebtedness. The IMF estimates that emerging economies’ funding needs total $2.5 trillion (Gourinchas, P., et al. 2020), but this figure may prove to be conservative if the crisis deepens. According to Reuters, emerging-market currencies have about $34 billion in USD-denominated debt maturing over the next 12 months (Chen, M., March 2020)
The current economic crisis, caused by an external shock, can be transformed into a banking crisis if the current measures are not effective enough to stop the expected increase in delinquency rates, bankruptcies, and mistrust in financial markets or in the economy.
Banks have been preparing in the past years to cover the risks of rising non-performing loans and loss of revenues, but the capital shortfall risk may be significant, particularly as most governments’ policies are designed to increase borrowing for businesses.
If this happens, the world banking system may not be ready to address the risk. Studies, such as COVID-19 Stress Test (March 30, 2020 Money & Banking), point out that “neither stress tests nor financial supervision in general has prepared us for a shock of this magnitude”. Some indicators to gauge the aggregate shortfall of capital in the financial system during a crisis (defined as a 40 percent drop of the global equity market over the next six months), are showing that aggregate capital shortfall could reach $3 trillion. The United States is the developed region less impacted by capital shortfalls. (Money & Banking, 2020)